This in-depth report is the second that discusses the possibility of a de-pegging of the Hong Kong Dollar (HKD) to the USD. In the previous report, we discussed the unsustainability of pegging the HKD to the USD when the Chinese economy is deteriorating and the Fed is raising interest rates, and we proposed a near-term, cost-minimizing de-pegging scenario while the HKD is still strong in view of capital inflows from the mainland that can lead to a win-win situation for both HK government and investors. However, the best option is not always the most realizable one. In our view, the HK government is likely to maintain the current system, even at high social and economic costs, in the expectation that changing external factors, such as the rebound of the Chinese economy, will relieve the de-pegging pressure.
In this report, we explore several approaches to gauge the timing and risks of a de-pegging of the HKD and the collapse of the Chinese housing bubble. At the same time, we analyze the potential impact of a de-pegging on HK’s local companies and the most vulnerable parts of the system.
Choosing the best timing is the most critical aspect of short sellers’ strategies for HKD de-pegging speculation, especially considering the HK government owns huge amounts of foreign reserves and has the capacity to gather support from the Chinese central government.
A fundamental practice is to check HK’s trade environment. Two types of data can be used for this purpose: the residency-based Balance of Payments (BOP) and the currency-based BOP. Each type of data has its own shortcomings due to the special status of HK as an international financial center.
An alternative solution is to assess the credibility of the HK currency peg by comparing interest rate differences between HK and the U.S.. Fung and Yu applied a Bayesian framework to the Svensson test. Rather than simply addressing whether the Convertibility Zone is either fully credible or non-credible, the Bayesian approach provides time-varying estimates about the evolution of the degree of credibility of the Convertibility Zone at each point in time. Their work results are shown in the following two diagrams.
In 2015, the Swiss National Bank (SNB) broke its promise of keeping a minimum rate of 1.20 Franc per Euro announced in 2011. Hong Kong Monetary Authority (HKMA)’s research into this event is worth paying special attention to, as the Institute had made a similar promise. Hui, Lo and Fong from HKMA studied the dynamics of the Swiss Franc and used market data to calculate the drift term and stochastic process. Their research is based on the assumption that the speed of the mean-reverting drift is estimated as a function of increasing foreign reserves. Through research on the drift strength, when the Franc was at its strong point, their result shows the condition for breaching the limit was met in November 2014, about two months before the SNB abandoned the cap. A similar approach can be used for speculating the timing for HKD’s de-pegging.
Monitoring HK fundamentals is important; however, investors have to consider the ‘honeymoon effect’ and the Krugman-type target-zone models which suggest that the exchange rate function will appear to be less sensitive to changes in fundamentals than the corresponding free-floating exchange rate. The effect of fundamentals on the exchange rate decreases when the exchange rate deviates from its central parity.
Furthermore, investors need to consider the well-being of the Chinese economy. The HKD is heavily reliant on China’s economy. During January 2016, the huge movement in the HKD had little to do with fundamentals in HK, but it correlated with changes on the mainland.
The Chinese housing bubble is regarded as the “Sword of Damocles” to the Chinese economy, and a collapse of the Chinese housing bubble could destroy investor confidence in the HKD. Therefore, gauging and estimating the timing of the collapse of the Chinese housing bubble is of great importance to investors, and the price of housing is an important parameter for this. Deng, Girardin, and Joyeux in their research papers offered a more accurate way than the official data to measure housing prices by taking into account every transaction that has taken place in China’s major cities.
Investors also need to model the dynamics of the development of China’s housing market. Yang and Gete’s research suggested that traditionally, productivity, land shocks, savings gluts, and tax policies are the key drivers. They pointed out that productivity and land shocks affect housing quantities more than prices, while savings gluts and tax policies affect prices more than quantities. Around 2014, they found that two new factors, housing preferences and credit shocks, were becoming increasingly important in explaining housing prices and volume, and population shocks started to explain a large share of the dynamics of residential investment. In 2016, credit shocks played an even greater role. Residential mortgages have become a major driver of China’s new credit and accounted for 70% of new monthly loans in August 2016.  As credit has evolved into a dominant role, the high profile Asian hedge fund manager Bei Leshi, who just funded his own fund, Lingfeng Capital, leveraged the Log-Periodic Power Law (LPPL) model to predict the timing of the collapse of the housing bubble based on the assumption that in order to maintain such a Ponzi scheme, credit has to match the power law.
(In June 2014, China M2 Growth Rate diverged from the Power Law)
Choosing a Target
When de-pegging is on the horizon, the next critical step is to assess the de-pegging impact on local companies and identify the most vulnerable part of the system as your target.
Previous financial crises in HK were usually caused by housing bubbles and banks’ unrestricted lending. When the risk of de-pegging emerges, banks are highly likely to become short sellers’ first choice of target. However, investors should notice that HK’s recent control of Loan-to-Value measures has reduced the exposure of banks in the real estate sector, and there is a possibility that the HK government will depart from its laissez-faire policy and directly support banks. Non-interventionism in HK has never been a matter of economic conviction, but primarily a question of political convenience.
In fact, HK’s bond market might be a better target for short sellers than banks. After the 2008 financial crisis, outstanding corporate bonds posted a fast growth rate of 17% per annum on average, far outpacing HK’s economic growth. The Bank for International Settlements (BIS) has already expressed concerns over such fast development of HK’s bond market. The bank pointed out that bond issuers are less confined to corporates with top credit ratings, and corporations with lower credit ratings are now able to gain access to the bond market. Also, as the pricing of corporate bonds are usually based on major government bond yields (notably the US Treasury yields), the increased use of bond financing could make corporate borrowing costs more sensitive to global monetary and financial conditions. Furthermore, there are huge mismatches of currency due to the low cost of issuing USD denominated bonds instead of HKD denominated bonds. As of the end of 2014, the outstanding amount of corporate bonds in HK stood at US$101.8 billion, of which 14%, 65% and 22% were denominated in HKD, USD and other currencies, respectively. When the crisis of de-pegging emerges, these low credit rating companies with large outstanding USD denominated bonds are expected to be hit hard, as de-pegging will not only hit their balance sheets but also worsen their financing situations due to their inverted capital structures.
Compared with the U.S. bond market, the HK bond market is narrow and the spreads quoted are quite wide, which makes it more vulnerable to an attack by short sellers. Besides, the structure of HK’s bond market also limits HK government’s capacity to support the HKD when it’s under attack. A similar case occurred back in the early-1990’s with the British Pound when the Bank of England’s ability to support the pound sterling was limited due to the fact that 90% of home mortgage loans were issued at floating interest rates rather than fixed interest rates. On the other hand, the Swedish central bank raised the interest rate to 75 percent (annualized) and limited the incentive to borrow weak currencies for speculative purposes and successfully rebuffed George Soros.
As the HK government is highly likely to support the current system, investors need to be alert to the government’s intervention and the ensuing trading opportunities. In this regard, a case study can be insightful. During the 1997 Asian financial crisis, the HK government spent hundreds of billions of HKD in supporting the market. Although no details have been revealed, Goodhat reviewed the government’s strategy based on an intensive study of market data and reports. His research showed that short sellers were highly leveraged and if speculators could push down the stock index by 1000 points within 100 days, the cost would be HKD 400 million and the net profit would be HKD 3.6 billion. In order to foil the speculators’ double-down strategy, the HK government conducted a counter double-play strategy, not only in the HK market but also in the London market, as many HK stocks are listed on both stock exchanges under different currencies. The fierce confrontation between the two sides created huge arbitrage opportunities. For example, during the two days before the August index futures expired, the prices of the London GBP trading with HSBC dropped considerably while the London HKD trading with HSBC and the HK trading with HSBC remained much higher. When similar scenarios emerge, investors who have carefully reviewed previous interventions and use their discretion in judging the circumstances are more likely to grasp trading opportunities, especially considering that under extreme stances, many algorithim arbitrage trading strategies have to turn down due to huge de-pegging risks.
This report has provided several methods for gauging the timing and risks of a de-pegging of the HKD and a collapse of the Chinese housing bubble. As far as target choosing, this report indicates that other than short banks and real estate companies, low credibility companies which have issued large amounts of USD denominated bonds might be better targets. Careful study of the HK government’s stock market intervention in the 1997 crisis will be helpful in detecting arbitrage opportunities.
. The first in-depth report on HKD can be found at https://sgi.seleritycorp.com/special-report-hong-kong-monetary-policy-outlook-hkd/
. The Nexus Of Official And Illicit Capital Flows –The Case Of Hong Kong, Yin-Wong Cheung, Kenneth K. Chow and Matthew S. Yiu, HKIMR Working Paper No.25/2015
.Assessing the Credibility of The Convertibility Zone of The Hong Kong Dollar, Laurence Fung and Ip-wing Yu, HKMA Working Paper 19 /2007
.See the press release “Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro” by the SNB on 6 September 2011 http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf.
 The HK government announced that it would peg the HKD to the USD at the rate of 7.80. Hong Kong’s Money The History, Logic and operation of the Currency Peg, Tony Latter, Hong Kong University Press, pp.55
. A Quasi-Bounded Model for Swiss Franc’s One-Sided Target Zone During 2011-2015, C. H. Hui, C. F. Lo and T. Fong, HKIMR Working Paper No.15/2015
. Fundamentals and the Volatility of Real Estate Prices in China: A Sequential Modelling Strategy, Yongheng Deng, Eric Girardin, Roselyne Joyeux, November 2015
. China’s Credit Fire Hose Floods Housing Market, WSJ, http://www.wsj.com/articles/chinas-credit-fire-hose-floods-housing-market-1473926793
. The bubble is Ripe, Beilesi, http://barrons.blog.caixin.com/archives/24765
. Mr. Bei is using M2 data in his public article, however in China, the social financing data might be more insightful data and it’s very likely Mr.Bei adopted such data in his trading model. Selerity has conducted an in-depth report on China’s social financing data and the full report can be found at: https://sgi.seleritycorp.com/special-report-shadow-banking-the-chinese-money-supply/
. Profits, Politics, and Panics: Hong Kong’s Banks and the Making of a Miracle Economy, 1935-1985, Leo F. Goodstadt, Hong Kong University Press, pp 163-181
. How Does Loan-To-Value Policy Strengthen Banks’ Resilience to Property Price Shocks – Evidence from Hong Kong, Eric Wong, Andrew Tsang and Steven Kong, HKIMR Working Paper No.03/2014
. The Global Crisis: Why Laisser-faire Hong Kong Prefers Regulation, Leo F. Goodstadt, HKIMR Working Paper No.01/2010
. The rise of Hong Kong’s corporate bond market: drivers and implications, David Leung, Ceara Hui, Tom Fong, BIS Papers No 83
. The Volatility Machine: Emerging Economics and the Threat of Financial Collapse, Michael Pettis, Oxford University Press, pp 132
. What Futures for The Hong Kong Dollar Corporate Bond Market? Tony Latter, HKIMR Working Paper No.19/2008
. Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis, Corsetti, Giancarlo; Pesenti, Paolo A.; Buiter, Willem H., Cambridge University Press, pp 57-58
. Intervention to Save Hong Kong: Counter-Speculation in Financial Markets, Charles Goodhart and Dai Lu, Oxford University Press, 2003, pp 39-96